Take My Stock, Please

This is a great time to have part of your portfolio in the shares of takeover candidates. You don’t even have to try very hard to wind up with at least a few. January’s cash-based takeovers (24 deals with a combined $15 billion purchase price) tripled 2005’s record level, according to Bloomberg. I expect February, March and all of 2006 to be no less robust. It’s growing, not fading.

After stocks got very cheap in 2002, corporations became very avid buyers of them. They either buy in some of their own shares or buy other companies outright. When either kind of buying takes place at a low enough price, the result is a boost in the earnings per share of the acquirer.

A low price, in this context, means that the acquired stock has an earnings yield better than the aftertax cost of borrowed money (or the aftertax return on idle cash). At the moment, the market’s earnings yield--that is, the inverse of the price/earnings ratio--is 6%. Pay a dollar and you get yourself an earnings stream that starts off at 6 cents. The aftertax value of cash is more like 3 cents. Use borrowed money or loose cash at a cost of 3 cents to get 6 cents of earnings and you are ahead. This process can continue until either the stock market or global long-term interest rates are way up, or earnings fall apart.

If a firm is cheap enough, it must either borrow money to buy back its own stock, driving up its price to eliminate that cheapness, or it will fall prey to an acquirer who does a hostile takeover. This rule does not apply to companies with insiders in firm control (the New York Times Co., for example), but it does apply to the majority of companies, which do not have insider control (Knight Ridder, for example). You can play the takeover game by owning cheap companies that lack controlling insiders.

Did you read somewhere that hedge funds aimed at takeover stocks have fared poorly? Don’t let that discourage you. Those hedge funds are playing the wrong game--the old 1980s arbitrage game of buying right after a deal is announced and profiting on the spread between the announcement price and the final deal price. This game is over because spreads are tiny and, in the era of Sarbanes-Oxley audititis, deals take forever to close. If you want to make money in takeovers, buy long before any announcement.

Just find stocks that could be taken over profitably and that you would be content to own even if they aren’t taken over. If they’re acquired, you win, and if they aren’t, you don’t lose.

Here are four acquisition candidates:

Korn/Ferry International (21, KFY), the executive recruiter, has four features making for a plausible takeover. It has a great brand name in headhunting and a global footprint. No one comes close to controlling it, so it can be shotgun wed. A market value of $800 million and revenue of $500 million make it small enough to be digestible by plenty of potential buyers and also too small to justify being independent in this fragmented market. Finally, it is cheap at 18 times the earnings it is likely to generate this year. Its only real defense is to buy back a lot of its own shares. That would drive the stock up.

For very similar reasons
Tiffany
& Co. (37, TIF) is a buy. Its brand is even better. (Can you think of any Marilyn Monroe, Sean Connery or Audrey Hepburn movies featuring Korn/Ferry?) Earnings are down a bit, but a steady history of moderate growth in revenue and good basic profitability mean that an acquirer bears little risk. At 16 times trailing earnings it is cheap enough. The big holders are money managers who would sell their mothers for a nickel.

National banking boundaries keep falling, so buy a bank that will be an important link in a global banking chain. A logical choice is the
Bank of Ireland
(72, IRE). This one is strong in its home country and small at $17 billion in market value.

It’s cheap at 11 times trailing and 2006 earnings. A buyer could borrow money at 6%, not even claim a tax deduction for the interest cost and still come out ahead owning an asset with a post-tax earnings yield of 9%.

Principal Financial Group
(49, PFG) spans investment services, retirement plans and health and life insurance. It’s not growing, but it’s cheap. While little known outside the industry, it has a wide net--with twice the revenue of
Charles Schwab
yet only two-thirds Schwab’s market value. I see it as a target of a brokerage firm, bank or insurance company. It sells at 13 times 2006 earnings. Any medium-grade corporation could buy it and boost its earnings per share immediately.